The Coming Potential Crisis

The Coming Potential Crisis: A Somewhat Brief Explanation

by Brandon Powers, BA Economics, Ohio State University

Let me start by saying that the following is not a politically charged rant. This isn't just some bullshit about the minimum wage, Obama, gun laws, etc. This stuff actually matters a great deal, and I'll bet that most people who read this have no idea whatsoever that this is even an issue.

A few days ago, the European Central Bank (ECB), headed by Mario Draghi (Ex-Goldman Sachs, Harvard) announced that they would now charge member banks to hold their reserves in their savings accounts, through the use of a negative deposit rate of -0.10%. In a normal savings account, the bank pays you interest. Now, the member banks will be paying the ECB interest.

I will try my absolute best to refrain from econ jargon and uninterpretable jibberish from this explanation, since the readers of this are likely not up to speed on Macroeconomics. However, it is a very complex issue and will require some thinking. The best way to explain the situation is through a series of questions and answers:

1. What are bank reserves?
2. How does borrowing and consuming create price inflation?
3. Why is price inflation desired by central banks?
4. Why and how does borrowing and consuming create boom and bust cycles?
5. What may happen to _____ if the Fed pursues a similar policy?
   1. The stock market
   2. The bond market; treasuries, corporate, junk, MBS
   3. The housing market
   4. Commodities
   5. Interest rates and the US Dollar
   6. US government debt
   7. The average American
6. What can be done to hedge against this risk?
7. The silver lining... or is it?
8. Why should you spread the word?

What are bank reserves?

Bank reserves are the amount of cash on deposit that banks hold above the reserve requirement. If you don't know anything about the American banking system, it goes like this; You deposit $1000 at 1^st American Bank. The bank loans out $900 of your $1000 deposit to a guy named Barry. They keep $100 in the vault due to the reserve requirement, in case you come wanting some of your money back.

It works very similarly for big investment banks, too. Think of the Federal Reserve, Fed, as 'the banks' bank,' where the big banks have accounts. So, bank reserves are like 'credits' to use as loanable funds.

Here is where our problem begins. In the US and in Europe, the big banks have been parking tons and tons of cash at the Fed and ECB, where it collecting interest at 0.25% APY. They have been stowing the cash that they have received from the Fed's asset purchase program known as Quantitative Easing.

Normally, this is where economists will go off into a spiraling series of explanations of intertwining issues... the joke goes, “Economists can be both clear and short, but not at the same time.”

So, the big banks have all these excess reserves parked at the Fed earning a tiny profit. So what? Well, the economy can't pick up speed if there are a lack of loans being made to businesses, consumers, etc. The banks are reluctant to lend because they're still nervous from 2008, you know, their near-death experience, and would rather make 0.25% risk free over lending at 3.5%. Not to mention, the banks are still on life support. But both the Fed and the ECB want banks to loan out the money to create price inflation.

How does borrowing and consuming cause price inflation?

Back to our bank story with you, 1^st American Bank, and Barry. Barry has taken out a $900 loan from 1^st American. Barry uses that money to buy a new reclining leather couch with cup holders so he can get the bitches. He bought the couch from Jeff, who now deposits that $900 into his account at 1^st National Bank. 1^st National Bank now loans out $810 (remember, 10% reserve requirement) to Hank, who buys a new exhaust system for his Honda Civic to make it sound mean and get the bitches. He bought the exhaust system from Ricky, who deposits the $810.... This is called fractional reserve banking, and it creates new money out of thin air.

This goes on and on and on and on until eventually, $10,000 of new money is created. The quicker way to find that out is to take the initial deposit amount, $1000, and divide by the reserve requirement, 0.10.

As this new money enters the economy, each dollar becomes slightly less valuable. If there are 1,000,000 apples at the grocery store but only 10 oranges, which one do you think has the higher price, all things equal? (You're comparing apples to oranges!) The oranges, because they are more scarce. So, if the money becomes slightly less scarce with each new dollar entering the economy, costs rise on basic materials, which works its way around until eventually businesses raise prices, that way they attain more dollars with less value and net-net receive the same real amount of profit.

Why is price inflation desired by central banks?

Central banks want low price inflation because they think it 'greases the gears' of the economy. (Please note: economies are not machines, they do not have set outputs for set inputs.) What that means is that if consumers anticipate the price of goods will rise next year, they will buy them this year, and that spurs Gross Domestic Product (GDP), of which 70% is made up of consumption. GDP is calculated by this simple equation:

Y = C + I + G + NX

Output (GDP) equals consumption spending plus investment spending plus government spending plus the value of net exports (imports minus exports). This is the standard measure of economic power in use today. Therefore, central banks want to keep the economy strong by encouraging spending, which we know causes price inflation.

How does borrowing and consuming create boom / bust cycles?

First, let's start with the definition of a boom and bust. Booms are times of growth, when GDP annually grows at a rate < 2%. Busts are when GDP contracts, or has a negative growth rate, for more than two consecutive quarters. This is also called a recession.

During the boom phase, consumers and businesses take on more debt. Consumers borrow money to buy cars, houses (eek! 2008!), furniture, vacations, anything! They will take on more debt if interest rates are low. As they spend this money, businesses expand in order to keep up with the consumer demand, which they are able to do with low interest rates. Prices start to rise as each dollar becomes less valuable in the economy. Eventually, the creditors will start to raise interest rates (which if you think about it is also a price; the price of money).

During the bust phase, interest rates begin to rise. The cost of borrowing rises. Consumers slow spending and start to pay down their debts because of the increasing interest payments. Businesses, which have expanded to meet the consumer demand, must cut back due to the decrease in consumer spending. This means layoffs, since the first and highest cost to businesses is labor. As more people become unemployed, they spend less, and save what they can. This is helped by rising interest rates: would you rather deposit your money and earn 2% or 5%? As more and more consumers save their money and pay down debt, interest rates fall, and before long the economy is back in the boom phase.

For the sake of simplicity, we will say that this is the natural state of markets and the economy (it's not). Because this is “normal,” what's the problem? The central bank!

Think of it like this: the central bank pumps money into the economy through asset purchases. They buy these assets (treasury bonds) with reserves from the big banks, who loan out the reserves. Those reserves collected from the asset purchases by the central bank are like “fake savings.” They achieve the same result as actual savings; it lowers interest rates. The difference is that consumers spend money they don't have, which means that the boom is 'artificial.' The businesses that expand are being duped into thinking that this spending can continue, when it really can't.

My personal favorite analogy to explain this goes like so: A man owns a restaurant in a town. One day, the circus comes to town. Every day from open to close the restaurant is packed with clowns. The man can't see that they're clowns, though, so he thinks it is real demand for his food. He opens up a second restaurant on the other side of town, which also gets packed every day with clowns. Eventually, the circus leaves town, and sales at the restaurant plummet. The man, not knowing that this was only temporary demand, has to close down both restaurants because he can't afford to keep them open due to the loss in sales and rise in interest payments on his loan for the second restaurant. As a result, his workers are now unemployed and the bank that loaned him the money has a default on their books.

What may happen to _____ if the Fed implements the ECB policy?

Remember, the Fed wants banks to lend their reserves out and create inflation which (in their minds) will boost the economy. The banks don't want to lend because they can earn 0.25% risk free on $4 trillion worth of excess reserves. If they Fed were to implement the ECB policy, and make that 0.25% into -0.10%, the banks would have a higher incentive to lend the reserves out. So what will happen to...

The Stock Market

Stocks will likely rise in the short run after the announcement. Higher prices means higher profits, and investors like profits. In the long run, the following scenarios would do a lot of damage to stock prices.

The Bond Market

Yields will rise on bonds. As new money enters the economy, prices rise, including interest rates. For those of you that don't know how bonds are priced, I'll simplify. If interest rates rise, bond prices fall; they have an inverse relationship. If yields (interest rates) rise on bonds, investors lose money.

Some of you may have heard in the news recently that the big banks are more profitable than ever before. And you might think, “Wait, I thought they were just on the brink and had to be saved with MY tax money?! And if they aren't making loans, where are the profits coming from? Dafuq yo!” That's because they have been borrowing at near 0% interest and buying treasury bonds and other bonds that yield 2.5%-5% and leveraging that 60 times over, making huge profits. This is called a carry trade, and has become the main business of the banks, not lending.

If yields rise on treasuries, corporate bonds, junk bonds, and mortgage-backed securities (MBS), then this carry trade profit machine would quickly turn into a loss machine, and banks would be right back where they were in 2008. I mean, this is the real-life Walking Dead. Many, many more things could happen if yields rise significantly on bonds, but to explain them all would take 20 pages.

The Housing Market

So we all know that the housing market collapsed over the course of 2006-2010. That is a topic for a later date. Prices have since begun to rebound, starting in 2011. In fact, prices are higher than they were at the peak of the bubble in markets like San Francisco, where the median home price is $800,000! But, home ownership rates have only recovered slightly, and 1^st time home buyers are near all time lows. This is due to the very small spread of mortgage rates. If the prime rate (the best interest rate available, applies for those with excellent credit, etc) is only 3.5% on a 30yr mortgage, the bank won't make that much money. It is also due to the fact that many of those who would be 1^st time buyers are still laden with debt they took on during the bubble years, and many are chained with heaping student loan debts, rendering them bad candidates for mortgages. So how have prices risen? As soon as home prices began to bottom in 2010, a furor of speculation resulted in homes being bought up left and right in all cash deals. Therefore, housing prices have not recovered 'naturally.' It's reminiscent of the bubble days.

Not to mention, many current home owners are still underwater, meaning they owe more on their mortgage than what the house is currently worth. Many home owners can barely afford their homes at current near all time low rates. If interest rates rise, how will people be able to afford homes at all? The bottom will fall out yet again in the housing market.

Commodities

Think back to what was said about price inflation. As the new money enters the economy, the devaluation will affect the price of basic materials and commodities first. Things like oil, natural gas, food, etc. As the prices of these rise, the costs on businesses will rise and they will raise prices. If we do some simple math using the reserve requirement ratio and the chart of excess reserves shown before we can make a rough guestimate as to where the price of oil could be should all that money make its way into the economy.

Reserve Ratio: R = .12

Excess Reserves = $2,544,000,000,000

254000000000/.12 = $2.12e^13, or $21,200,000,000,000

Twenty one trillion, two hundred billion dollars.

Don't take this too literally, but that could send oil prices to $600/barrel, all things equal. Gasoline where I live in Ohio is about $4/gallon. With WTI Crude prices right at about $100/barrel currently, that makes the price of gas about 4% the price of crude. Assuming that remains constant, gasoline could be as much as $24/gallon. You get the picture?

Interest Rates and the US Dollar

If inflation begins to pick up when the banks start lending out the excess reserves, interest rates will absolutely have to rise. The US dollar will lose value compared to other currencies, making imported goods more expensive. Most of the goods we use each day are imported, so that would affect households greatly.

US Government Debt

The national debt, only including what the US Government owes to its bondholders and not to future liabilities like Social Security (mega ponzi scheme by the way), stands at $17,555,437,713,940 as of April 2014. The Government currently pays interest on that debt at very low rates and on very short term maturities. If interest rates rise, the burden of paying down that debt becomes much heavier, and a very large portion, if not all, of revenues will go just to 'servicing the debt.' You know what that means? MUCH higher taxes, because of how overextended the Government is. Our creditors, China, Japan, etc., will want to see higher taxes so that they will have faith that our Government will be able yo pay what they promised on the treasury bonds they hold so much of (trillions worth). It also means drastic spending cuts will have to be made, but who knows what they'll cut? Everyone wants their hand in the honey pot; “You can't cut my Social Security! My Medicare! Welfare! The Military! The EPA! Nothing!” They through an enormous fit when the Government shut down for a couple of days, and when the 'sequester' of $85 billion worth of cuts were made in March of last year.

The Average American

So, according to what I've just listed, shit looks rough. Higher prices, higher taxes, you name it. If the Fed cannot contain the inflation they want so badly, the economy will spiral into a much worse recession than the fiasco of 2007-2009. And I wouldn't have much faith in our wise overlords at the Fed to save the day, either. Here's Ben Bernanke, former chairman of the Federal Reserve, being absolutely wrong on everything that was coming during the housing bust:

What can be done to hedge against this risk?

Unfortunately, this is not so easy to explain. One could say leave the country, or put your money in a Swiss bank account, what have you. The most I could offer is to hold what money you can in physical gold. Gold throughout history has always been seen as valuable, no matter what has happened. If those pieces of paper that we call Dollars (not backed by gold since 1971) lose their value substantially, you make look like this:

In addition to gold I'd hold physical commodities... anything tangible that would have value to someone. That's being extremely vague, but consider a world where dollars are not the preferred medium of exchange when you think about what has value.

The silver lining...?

Aside from all the gloom and doom, this is actually not all that likely to happen. I think (...I hope...) the Fed is not that stupid to try and let loose 22 trillion dollars. That said though, it could be unavoidable. The Fed has no 'exit strategy' of how to get out of the economy, so to speak. They have no solid plan on how to control all those excess reserves should they start flowing out from the coffers of the Fed. Hell, the Fed itself could potentially become insolvent!

While I don't think the Fed will step out into the unknown like the ECB, I would not put it past them. And even if they don't the aforementioned scenarios can still very well play out. You don't create all that money that quickly and expect there to be no inflation forever!

Why should you spread the word?

The American people have had the story all wrong since the fiasco of 2007-2009. It was Bush's fault! Obama's fault! Warren Buffet's fault! The evil banksters! The 1%! It's all wrong. It's the Fed that everyone should be worried about. The 12 members of the Federal Open Market Committee (FOMC) are the most powerful people in the world, even more so than the President and Congress. They control the nation's money, and are unelected. Many of them are 'revolving door' cronies, coming from the likes of Goldman Sachs, Morgan Stanley, Harvard, and other big evil institutions. If you want to point fingers, point it at them!

What this country needs is a return to what made us great. Free markets, low regulations, low taxes, individual liberty, a much smaller military presence, and sound money; unaltered by the likes of our wise overlords at the Fed. That sounds like a Republican ideology, but it's not. Both political parties are the same. They're bad. Here's Stefan Molyneux's famous rant on the idiocy that is voting:

I'll end with this: You have been warned. Don't take this lightly. Read and research for yourself, and don't believe what the fuck nuts in Washington say about the economy, it is NOT recovering.